Atkinson, A. A., R. D. Banker, R. S. Kaplan and S. M. Young. 2001. Management Accounting: 3rd edition. Upper Saddle River: NJ: Prentice Hall.

Chapter 3
Cost Management Concepts and Cost Behavior

Study Guide by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

ABKY Main Page

1. Introduction

The theme of this chapter is "different cost for different purposes". On page 83 ABKY say that cost is like a chameleon. Most of the chapter is related to defining the terminology related to costs, i.e., the different types of costs that are associated with different types of decisions. Costs are assigned to cost objects following generally accepted accounting principles (GAAP) so that general purpose financial statements can be prepared for external reporting. Many other types of cost information are developed to support internal decisions. Illustrations 5 and 6 in the ABKY Chapter 1 summary show that different audiences need different types of information. In addition to defining a considerable number of cost types and other terms, the authors discuss why GAAP uses a functional approach to defining types of cost, the concept of cost-benefit analysis, how cost structures differ today, the activity cost hierarchy, and life cycle cost. They also provide an example to illustrate the concept of relevant cost.

2. Management Accounting Terminology

Cost or other Term	Definition	More Specific Definition or Example
Cost	Sacrifice	The price of any resource.
Cost object	Any segment or element for which cost information is desired.	A product, service, project, activity, department, division, etc.
Direct cost	Cost used by a single cost object.	A cost that would be eliminated if the cost object is eliminated. A supervisor's salary is a direct cost to the production department he or she is in charge of or managing.
Indirect cost	Cost that is common or shared by more than one cost object.	A production supervisor's salary is an indirect cost to the products produced within his or her department.
Flexible resource	Resources that generate cost in proportion to the amount used.	Direct material.
Flexible cost	Cost of flexible resources. Always direct costs. Cost that vary in proportion to the amount used.	Direct material costs, i.e., cost of materials or components that go into or become the product.
Capacity related resource	Resources purchased in advance. Committed resources.	Resources that generate cost based on the amount acquired rather than the amount used. Buildings and equipment.
Capacity related cost	Cost that are based on the amount acquired rather than the amount used.	Can be direct or indirect, but are fixed in the short run. Depreciation on buildings and equipment.
Variable cost	This term is not defined in Chapter 3, but it is a cost that changes or varies with changes in the activity level. See Chapter 5, p. 182.	Direct material.
Fixed cost	A cost that does not change or vary with changes in the activity level.	Capacity related cost. See page 83. Straight line depreciation, a supervisor's salary, property taxes.
Matching concept	I don't think matching is defined in this chapter, but it is the idea of bringing cost and benefits together on the income statement in the same time period.	Accrual accounting where benefits (revenues) are matched with the costs (expenses) associated with generating the benefits.
Expired cost	A cost associated with an object who's benefits have been obtained or recorded.	An expense such as cost of goods sold.
Unexpired cost	An asset.	Inventory until sold, buildings, equipment.
Expense	An expired cost. See above.	Cost of goods sold.
Asset	An unexpired cost. An object with expected future benefits.	Inventory, book value or undepreciated cost of buildings and equipment.
Product cost	Costs associated with producing a product that are capitalized in the inventory, i.e., become assets until the products are sold.	Direct manufacturing costs such as direct materials and direct labor, as well as indirect manufacturing costs usually referred to as factory overhead.
Inventory cost	Product costs. See above.	See cell above.
Manufacturing cost	Cost associated with the production of products. Factory costs. These are unexpired costs (assets) until the products are sold, then are charged off as expense, i.e., cost of goods sold	Includes direct material, direct labor (direct manufacturing costs) and indirect manufacturing costs also referred to as factory overhead and factory burden.
Non-manufacturing cost	Cost not associated with the production of products, but with some other function such as administration or distribution. Treated as period costs by GAAP.	Distribution, selling, marketing, customer service, research and development. See page 77.
Period cost	Cost that are expensed in the period in which incurred.	Non-manufacturing costs according to GAAP. See above.
Incremental cost	Cost of one more item, unit or customer.	Cost of one more passenger on an airline.
Full cost	Direct plus indirect cost. Variable plus a share of the fixed costs.	GAAP product costs is considered full costs although this is misleading because it does not include non-manufacturing costs.
Historical cost	Recorded costs. Sometimes referred to as actual cost, but this is misleading because the cost recorded depends on the accounting alternative chosen.	Any costs that are recorded such as labor costs, materials costs, depreciation etc. For example, accounting alternatives for depreciation include straight line and several accelerated methods.
Future cost	Estimated costs.	Budgeted costs.
Average cost	Usually refers to the mean of a category of costs.	The unit cost of a product that flows through a production process.
Implicit cost	Unstated and unrecorded cost.	Opportunity costs.
Opportunity cost	Benefit foregone by not accepting or pursuing the next best alternative.	The income or interest on an alternative investment. The opportunity cost of owning anything is what you could have obtained with the money.
Short run	ABKY define this as the time period where a decision maker cannot adjust capacity. See page 83.	Usually thought of as a year in accounting, but this is just a ball park number and depends on the type of resource involved. The short run for an inter-state highway, or factory building is longer than a year and for a resource like fork lift trucks, it would be much shorter than a year.
Long run	The opposite of the above where capacity can be increased or decreased.	See the cell above.
Short run cost	ABKY define these as flexible costs. See page 83.	Direct material.
Long run cost	These can be flexible or capacity related according to ABKY.	Depreciation on plant and equipment.
Discretionary cost	Can be increased or decreased at the discretion of the decision maker. Not committed.	Advertising, employee training, research & development, preventive maintenance.
Business level or sustaining cost	Capacity related cost.	Buildings and equipment.
Activity cost	Cost associated with different types, or levels of activities.	Unit level, batch level, product level, customer level and business level. See below and exhibit 3-7 on page 93.
Unit level cost	Cost of an activity that is required or performed each time a unit of product or service is produced or provided.	Direct material required for a unit of product.
Batch level cost	Cost of an activity that is required or performed each time a batch of products or services is produced.	Setting up the production line to produce a batch of product X. Also inspecting the batch, moving the batch etc.
Product level cost	Cost of an activity that is required or performed to support a specific product.	Product engineering.
Customer level cost	Cost of an activity that is required or performed to support a specific customer.	Sales calls, installation of a product and technical support.
Business (or facility) level cost	Cost associated with maintaining the business and facilities.	Maintenance, housekeeping, and administrative functions.
Relevant cost	Cost that will be different when two or more alternatives are involved. Also called differential cost.	The cost that will be different if a product is dropped. See note below related to the example on pages 93-96.
Life cycle cost	Cost associated with the various stages of a product's life cycle. See page 98.	Cost of product: 1. Development and design, 2. Introduction, 3. Production, 4. Distribution, 5. Post sales service, 6. Product take back, and 7. Abandonment.

3. Why GAAP Uses A Functional Approach to Cost

This section relates to why costs are separated into manufacturing and non-manufacturing categories. On page 79 ABKY say the answer to this question is not clear, but it is probably related to idea that different people are responsible for different functions. Other explanations are related to the matching concept (i.e., why manufacturing costs are charged to the inventory and non-manufacturing costs are charged to expense) and include the following.

1) The benefits associated with many of the non-manufacturing activities are received in the period in which the activities are performed and the costs are incurred, e.g., most distribution, selling, and after sale service.

2) The amount and timing of receipt of the benefits from other non-manufacturing activities are too difficult to estimate, even though future benefits are expected, e.g., advertising and research and development.

4. Cost Benefit Analysis

There is a short discussion on pages 79 and 80 related to the cost-benefit tradeoff for cost information. The idea is to develop the expected value of different alternatives. Determining the expected value of an alternative is calculated by multiplying the expected result by an estimate of the probability of the result. This topic extends well beyond the scope of this textbook, but the point is that information is not costless. A decision to capture a new type of information, or develop or improve an information system, always involves costs. The question is always whether the expected benefits will exceed the expected costs.

5. Cost Structures Today

In the section on pages 88 and 89, the authors discuss why the old cost allocation systems that allocate indirect cost based on a production volume related measurement such as direct labor cost now produce inaccurate or distorted product costs. There are a number of reasons for this but in general, capacity related costs now represent a much larger proportion of total manufacturing costs than in the past, and direct labor costs represent a much smaller proportion. There is also a lot more automation and a lot more product diversity than in the past. Many indirect costs, or support costs, do not vary in proportion to production volume. The ABKY example of an electric company shows that meter reading and billing costs do not vary with the volume of electricity produced and sold. When these costs are allocated to the various classes of customers based on the volume of electricity (i.e., the conventional costing shown in Exhibit 3-6), industrial and commercial customers are overcharged and apartments and homes are significantly undercharged. The electric company is actually losing money on Apartment customers as shown in Exhibit 3-5.

6. The Activity Cost Hierarchy

The cost hierarchy is included in the table above and discussed on pages 90-93 in the text. The implications of separating cost into activity cost pools is illustrated fairly well in Exhibit 3-7. Cost are separated into different cost categories based on whether they are related to units, batches, specific products, specific customers, or facilities. This allows the cost in each category to be traced to cost objects in different ways, instead of combining all indirect cost into a single cost pool and treating them as unit level or unit related costs. The main idea is to avoid the cost distortions mentioned above. This is the activity based cost approach that is illustrated in Chapter 5.

7. Relevant Cost Example

There is a somewhat involved example on pages 93-96 designed to show that the cost of acquiring resources is very different from the cost of using resources. The example involves three products and the decision of whether or not to drop product 3. The illustration shows that all of the costs, except the $2,400 cost of plastic, are capacity related costs and will not change if product 3 is dropped. In the short run, the only relevant cost for this decision are those costs that will be different. ABKY cover relevant costing in more depth in Chapter 6.

8. Life Cycle Stages

Different authors define the stages of the product life cycle in different ways. ABKY define these stages as: Product development & planning, Introduction, Growth, Maturity, Decline & Abandonment. Some authors indicate that the stages are different depending on the perspective as indicated in the table below. As ABKY point out on page 98, there are many types of product related costs and these costs occur unevenly over a product's life cycle. All costs need to be considered in product related decisions, not just the current costs of production and distribution. Also, products need to be evaluated differently at different stages of their life cycle. Mature products support products in the design and development stages. A company's strategy changes from growth and market share in the early stages to profits and cash flow in the later stages of the life cycle. The PLC concept is closely related to the value chain concept and recognizes that everyone along the value chain is important including society as a whole. For more specifics on the product life cycle concept click on the link below the table.

Perspective	Product Life Cycle Stages
Marketing or Sales Perspective	Startup - Growth - Maturity - Decline - Abandon
Production Perspective	Conception - Design - Development - Production - Logistical Support
Customer or Consumption Perspective	Operations - Support - Disposal

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Questions

1. What are some different uses of cost information? See item 5 in Chapter 1 Summary.

2. Why do different types of cost information need to be reported to support different managerial purposes and decisions? See item 6 in Chapter 1 Summary.

3. What is a cost object? See Terminology above.

4. How is it possible to distinguish direct costs from indirect cost? See Terminology above.

5. Explain the difference between flexible costs and capacity-related costs. See Terminology above.

6. Are flexible costs always direct? See Flexible resources and costs above.

7. Are capacity related costs always indirect costs? See Terminology above.

8. How are costs in a manufacturing firm classified for external reporting? See Terminology above.

9. Describe the difference between costs and expenses. See Expired and unexpired costs above.

10. What are the two principle categories into which manufacturing costs are classified? See Manufacturing costs above.

11. What are six categories of costs, classified by function, that are included in non-manufacturing costs for external reporting? See Non-manufacturing costs above.

12. Why do traditional cost accounting systems tend to analyze manufacturing costs in greater detail than they do other functional categories of costs? See the Matching concept above.

13. What are two broad purposes for which costs are used inside an organization?

14. Explain why you agree or disagree with the following statement: "An organization should have the most accurate and complete cost system possible." See Item 4 above.

15. What is an opportunity costs? See Terminology above.

16. What is the distinction between short run costs and long run costs? See Terminology above.

17. How has the composition of manufacturing costs changed in recent years? How has this change affected the design of cost accounting systems? See Item 5 above.

18. What are five categories of production activities? Explain the differences among them. See Item 6 above.

19. Why have customer-related costs attracted increasing attention in recent years?

20. What are the five stages in a typical product's life cycle? What is the cost focus in each stage? See Item 8 above.

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